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Financial Plumbing (a/k/a What’s Keeping Me Up At Night)

As we find ourselves in the midst of another financial crisis, it is time you learn about our country's financial plumbing.

Times of crisis are usually also amazing opportunities to learn something new.   This wisdom was imparted on me by a good friend during the last financial crisis ~2009.    He noted with fascination the number of detailed research-rich articles one could find that described how the various failing and defaulted businesses worked and ultimately got into trouble.

As we find ourselves in the midst of another financial crisis, I believe a different yet just as compelling opportunity for learning can occur.   I believe, dear reader, that this crisis will afford more people with the opportunity to better understand how our financial plumbing is set up and moreover why current calls for measures of certain kinds simply don’t make sense from a systematic standpoint.    Our system depends on the flow of funds...and that flow has been heavily disrupted...the pipes are clogged and badly.   

Let’s think about housing for a moment.

In normal circumstances, assuming you are employed at a “normal” job, dollars flow like this:

- You receive your paycheck; 

- You pay your rent or mortgage, assuming you don’t own your place outright;

- Your landlord collects payment and in turn pays the mortgage on the property assuming your landlord doesn’t own the property outright and also pays some taxes periodically (from part of your rent)

- Your mortgage servicer takes a small fee from your payment and diverts the rest of the proceeds to the mortgage holder and may also escrow taxes.

What happens when economies “close” or are put on pause:

- You might not receive a paycheck as expected, and maybe not for a while;

- Maybe you cannot pay your mortgage or rent because you don’t have the money

- Your landlord doesn’t collect payment and cannot in turn service the mortgage on the property and cannot escrow for taxes

- Your mortgage servicer does not collect a small fee from your payment and has no proceeds from you to remit to the mortgage holder or to escrow for taxes.

If your lender is a bank, they are able to grow retained earnings as loan payments are made and in turn extend new loans (in theory) to new borrowers and help facilitate new transactions.    If banks are not able to extend new loans, new transactions are few and far between.   

Look forward to court cases for the next 100 years and everyone is going to sue everybody because why the hell not. 

I am a free markets guy, federalist, libertarian...but I also think I am pragmatic.   I don’t see how the current basic system will survive what we are going through and about to go through without some extremely creative measures.   Why do I say this…?

Why whatever is being called for that’s not systematic probably won’t work:  
salary loans old photo bank loans cares act

- Closing the economy and simply expecting that people will figure it out won’t work.   Landlords have their own mortgages and taxes to pay on their properties and your mortgage holder and local governments are expecting tax payments.   Assuming these things will just be “figured out” on a case by case basis without significant damage is naive.   Evictions and foreclosures, even if just delayed, will skyrocket and local governments could face fiscal issues, etc.   

- Commercial rent strikes won’t work.   Same as above...assuming the landlord has the capacity to absorb the loss of rent and also proceeds for taxes is naive.     Expect a lot of difficult conversations and messiness. 

- Threats of foreclosure and eviction won’t necessarily work.   

- In the near to perhaps medium term, most landlords would rather have a tenant that might pay again versus having to go through the process of finding a new tenant, especially if this economic downturn lasts for a while and is as deep as it appears it could be.

- Foreclosing on properties in mass when the market lacks any new buyers away from distressed / deep-value players isn’t a realistic solution for lenders as the losses they could crystalize could require significant recapitalization.  

- Assuming landlords do evict and lenders do foreclose in mass...look forward to court cases for the next 100 years and everyone is going to sue everybody because why the hell not. 

- Sending people $1,200 or similar one time and expecting that to bridge the gap doesn’t work when the length of this situation is likely simply “longer”.

- Providing low interest rate forgivable loans that might keep people employed for another 8-weeks doesn’t work for the same reason the $1,200 checks don’t work (duration mismatch is likely high).

- Assuming that things will just snap back whenever (however) the all-clear is declared won’t work as a number of businesses (perhaps a great many) will no longer exist and it’s hard pressed to see how someone else will be there to take over the restaurant, the bar, the shop...

I want to pause here for a moment.   Perhaps, and I mean perhaps, there is some solution where things can literally freeze and unfreeze in lockstep and in some holistic manner.    Given the number of parties / actors and dollars in question, this seems on one hand like a herculean task and on the other maybe just the sort of thing that everyone would agree to if mandated by the powers-that-be, given the situation...nothing in-between seems plausible. 

So far I have been speaking about the housing market.   The same principles apply to all loans.   Defaults and bankruptcy filings have already started to pile up (again) in the oil, gas, and retail sectors.   News has come out in recent weeks suggesting that large bank lenders to the oil and gas industry are planning to return to a 1980s operating plan whereby they form LLCs to own and operate assets that they takeover when borrowers default.   This COULD reduce loss crystallization or at least creates more runway for optionality for lower losses later if businesses can be sold when commodity prices bounce back.  One Federal Reserve Bank president has even called for banks to raise sizable new equity NOW to avoid having to take another round of federal bailout money due to expectations for meaningful loan losses over this cycle. 

Attention is now being paid to the potential for pain in the CLO market.   The speed of ratings downgrades and loan migration to non-paying status could leave many managers with little choice other than to fire-sale some holdings.    People have begun to speculate about payments being cut off to the lower tranches of various structures as cash flows shrink.   This part of the market was largely shielded from the last crisis but will likely feel pain this time around.   A lot of the loans in these structures are covenant light, and absent a maturity default, leave lenders/holders little in the way of options along the way.   The bid/ask spread from a CLO seller to an opportunistic credit buyer is likely meaningful...potential mark to market losses for CLO managers are likely much higher than people anticipate.   This may not be a systematic issue, but the loss of CLO new loan demand will change the dynamics in the credit markets, both for better and for worse.

Insurance companies and pension plans are big holders of fixed income assets, generally speaking.   Think liability (claims and pension payments) matched (or not, as most pension funds are scarily underfunded...perhaps a topic for another day) with assets (cash flow streams from fixed income securities).   What happens when things get out of balance, for instance when cash-flows in are lower - and perhaps a lot lower because borrowers who are not servicing debt or investments in funds that in turn invest in the credit markets get hammered for the same reasons - and premiums MUST go up.   If people cannot afford their mortgage or rent, how are they going to manage through insurance rate inflation?  How are already underfunded pension funds going to manage to stay solvent?   If benefits are cut (which is the only solution absent a bailout), how does that in turn impact the ability for pensioners to pay rent / mortgages?  Illinois is likely angling for federal attention to address its fiscal issues, including its pension liabilities...and it’s just beginning.   

I could go on but I think this is a good place to stop.   I don’t have a solution...I don’t know how this all shakes out...I don’t know what’s on the other side of this thing.   Ask me, and I’ll either tell you this could be lights out or that, given the magnitude, there is no choice but for something to come together that prevents lights out.   The issues with the plumbing are definitely keeping me up at night...













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